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It is easy to be negative. Congress’ latest debt limit deal accomplishes very little and sets up another DC crisis later this year. What are the primary problems with the latest deal?

It calls for expenditure cuts of $2.4 trillion over ten years, an amount that is insignificant relative to the government deficit;

Discretionary expenditure reductions of $917 billion over the next decade will start this October as the country falls back into a recession;

Discretionary outlays are the easy target. But this means education, transport, science, and energy will probably be hit hardest. No revenue increases are included in the deal; and

The country will have another debt ceiling crisis in late November/early December when a Congressional committee is supposed to come up with another $1.5 trillion in budget savings.

Follow up:

$2.4 Trillion Over 10 Years is Insignificant

Table 1 indicates how insignificant the $917 billion expenditure decrease will be in reducing the Federal deficit. In 2021, the deficit would still be $607 billion. Assuming Congress can agree on an additional $1.5 trillion in cuts, and they are fazed in the same manner as the $917 billion in cuts, the 2021 deficit would still be $352 billion.

Table 1. – US Government Deficit Projections

For $917 Billion in Expenditure Cuts

Source: Congressional Budget Office

Table 2 gives Federal budget totals by function as well how they are expected to change between 2011 and 2020. As one can see, the big ticket items are Health, Defense, and Social Security.

Table 2. US Government Budget Authorizations (in bil. US$)

Source: Office of the US President

Not surprisingly, interest payments are projected to grow most rapidly over the next 9 years.

Discretionary Outlays

As indicated above, the expenditure reductions just approved are from the “discretionary” part of the budget. Table 3 provides detail on discretionary outlays by function.

Table 3. - US Government Discretionary Outlays by Function, 2011

Source: Congressional Budget Office

The elephant in the room? Defense. Virtually the entire Defense budget is discretionary. What are the Afghanistan and Iraq wars costing the US annually? CBO estimates the wars are costing $170 billion annually. Their estimate based on current plans is that by 2021, these wars will have cost $1.7 trillion. What could possibly justify this large outlay? I have argued that more US lives will be lost and absolutely no benefit will come from keeping soldiers deployed in these countries for another day.

But the Republicans who are pressing for smaller government/lower expenditures do not share this view. They oppose reductions in the Defense budget. So do the lobbyists working for the defense industry. According to Open Secrets, the defense lobbyists took home $146 million in 2010 and they are still working hard.

Look again at Table 3. Where will the discretionary budget axe fall? Probably education, transportation, science, and energy.

Revenue Gains Not Included

In an earlier article, I came up with following revenue-raising ideas to reduce the deficit.

1. End the Exclusion of Employer Contributions for Workers’ Health Care

If your employer pays for your health insurance, he deducts the payment as cost from his tax base, and you get free health care. This treatment is unfair to the person who pays for his own insurance. From a distributional perspective, it hurts poor people more because they are less likely to have an employer who pays their health insurance. To rectify this, the company’s health payment should be added to the recipient’s income, and the recipient should be allowed to deduct this expense from their tax base. Stabilization Effect: This reform would generate $165 billion annually for the Federal government.

2. Increase the Gas Tax by $1

Per capita, the US consumes almost four times as much gas as other OECD countries. Why? Because US energy policy has been to keep gas prices as low as possible. In contrast, European and Japanese gas prices have been in the $6-$7 range for at least a decade. So the US drives more in bigger cars. The US now imports 67% of its crude oil, and this percentage is growing. Allocation effects of the proposal: It would discourage driving and encourage the use of more fuel-efficient cars. Income distribution effects: its burden would fall more on low-income people who must use their cars to get to work. Stabilization: Increasing the Federal gas tax by $1 per gallon would generate an additional $138 billion annually.

3. End the Mortgage Interest Deduction

Is there any reason why the tax code should give people who purchase their home a break relative to people who rent? I don’t see it, especially after the home buying excesses of the last decade. Allocation effects: it would eliminate the subsidy for home ownership. Distribution effect: this tax break goes primarily to upper income people who often get bigger deductions, and often for more than one home. Eliminating this tax break would have to be done gradually. Stabilization effect: its elimination would generate $121 billion in additional tax revenues.

4. End the Tax Break for Dividends and Long-Term Capital Gains

Dividends and long term capital gains are taxed at lower rates than wages. The argument has been that these tax breaks stimulate investment. While the argument sounds plausible on its face, it does not hold up under scrutiny. The overwhelming majority of stock purchases do not increase the liquidity of the companies whose equities are purchased. Liquidity is added via stock purchases only when for new issues. Most purchases are made of equities already being traded and not new issues. Allocation effects: very little. Distribution: This tax break is of tremendous benefit to the wealthy. Stabilization: Eliminating this tax break would increase tax revenues $101 billion annually.

5. End the Exclusion of Capital Gains Taxation at Death

For some reason, the capital gains tax that would be due if assets were sold during one’s lifetime is forgiven at death. The result: the beneficiary gets the assets tax free. Allocation effect: this exclusion freezes stock purchases that would otherwise be sold to take advantage of the death benefit. Distribution: This benefit goes to people with considerable wealth. Stabilization: Ending this exclusion would increase revenues by $49 billion annually.

6. Legalize Drugs

The US should have learned from prohibition. The war on drugs is not working. Not only do drugs pour into the US, thousands of people die annually in drug wars resulting from the illegal profits being made. In an earlier article, I estimated that if the drugs were legalized and treated like cigarettes, the Federal government would generate $32 billion annually in tax revenues. In addition, states would get an additional $50 billion annually to help with their deficits.

Conclusions

While “throwing government at problems” makes no sense, this is not the time to cut government outlays in education, transportation, science and energy. Additional revenues are needed to keep this from happening. As Table 4 indicates, the tax changes discussed above would result in new Federal revenues of $606 billion annually. That is a lot of change. To put it in perspective – the current debt deal will save $2.4 trillion in the 2011-2021 period if Congress cuts an additional $1.5 trillion in expenditures later this year. My proposed revenue increases would generate revenue gains over the same period? More than $6 trillion.

Table 4. – Revenue Raising Possibilities, (in bil. US$)

Unemployment

8.8 million US jobs were lost in the global recession. Since then, the private sector has added 2.1 million jobs. But housing remains problematic with the consequence that construction continues to shed jobs. Falling state and local revenues has led to significant worker layoffs.

Republicans rail against tax increases, claiming they would be just the wrong medicine for a weak economy. They appear oblivious to the fact that the government expenditure cuts they insist on will slow growth by even more. Bernanke is aware just how fragile the recovery is. He is prepared to take further action. But a fiscal policy stimulus would be far more effective than anything he could do to strengthen the recovery. Before austerity programs kick in, we need a new fiscal stimulus package. No chance. And the growing awareness of how dysfunctional Washington has become will further delay the recovery.

Elliott Morss has a broad background in international finance and economics. He holds a Ph.D. in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires. During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries. In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar. He has co-authored seven books and published more than 50 professional journal articles. Elliott writes at his blog Morss Global Finance.

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2 comments

The entire exercise is illusory, as austerity will increase the deficits. No matter how many iterations. We cannot starve our way out. We need to earn our way out. Since that road is cut off, the likelihood is we won't get out.

I would prefer a carbon tax, or the Cantwell-Collins cap and dividend, plus eliminating the cap on payroll taxes and enacting a Tobin Tax to quell speculation as it raises revenue. Shifting the burden up the wealth scale raises revenue with the least damage to the multiplier.

I've just begun reading Jamie Galbraith's, "The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too" (2008), and in Chapter 3 he explains the consequences of cutting the tax rate on capital income. Under the pre-Reagan tax system capital gains were taxed at up to 70%, which encouraged companies to retain and reinvest earnings to forestall taxes. At today's 15% capital gains tax rate those companies are encouraged to pay out most of their earnings to shareholders (as dividends) but most especially as stock options to their managers. Galbraith writes,

"This accounts in part for the explosion of chief executive pay. ...The consequence has been a shift in the composition of investment--roughly from factories and other corporate forms of investment to residential houses and other private forms, fueling an exceptional boom in high-end home construction, visible across the American landscape."

Galbraith observes that the supply side argument that tax cuts for the wealthy will increase their savings and investment is true enough, but there is no public good gained by massively increasing investment in mansions and therefore no justification for capital income tax cuts as public policy. He further argues that if markets are efficient, there cannot be any public benefit to this kind of tax reduction, as efficient markets would allocate all of the return on capital to the capitalist who saved and invested his money, and all of the return on risk to the entrepreneur who executes the project. In the case of mansions, the capitalist and the entrepreneur are the same person, and he gets ALL the benefit of his increased savings and investment due to capital income tax cuts.

Galbraith concludes,

"Physical investment in business assets now occurs where the tax codes encourage it, by keeping income in corporate hands. (This is notably true, in particular, in China these days.) In the United States, thanks to Reaganomics and its Bush successor, this is no longer the case."

The thesis of The Predator State is that the myth of "free markets" is no longer believed by any but the most deluded true believers, and that the real policy of conservatives is corporatism, which is the anticompetitive antithesis of free markets. "Free markets" and "economic freedom" are a smokescreen, behind which America's small contingent of very wealthy people are gorging themselves on American pie at the expense of everybody else. I've got nothing against people getting rich by earning it, but lying hypocrisy and legalized theft really irks me.

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